Relative Goods' Prices, Pure Inflation, and the Phillips Correlation

60 Pages Posted: 27 Nov 2007 Last revised: 3 Oct 2010

See all articles by Ricardo Reis

Ricardo Reis

London School of Economics & Political Science (LSE); National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Mark W. Watson

Princeton University - Woodrow Wilson School of Public and International Affairs; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: November 2007

Abstract

This paper uses a dynamic factor model for the quarterly changes in consumption goods' prices to separate them into three independent components: idiosyncratic relative-price changes, a low-dimensional index of aggregate relative-price changes, and an index of equiproportional changes in all inflation rates, that we label "pure" inflation. The paper estimates the model on U.S. data since 1959, and it presents a simple structural model that relates the three components of price changes to fundamental economic shocks. We use the estimates of the pure inflation and aggregate relative-price components to answer two questions. First, what share of the variability of inflation is associated with each component, and how are they related to conventional measures of monetary policy and relative-price shocks? We find that pure inflation accounts for 15-20% of the variability in inflation while our aggregate relative-price index accounts most of the rest. Conventional measures of relative prices are strongly but far from perfectly correlated with our relative-price index; pure inflation is only weakly correlated with money growth rates, but more strongly correlated with nominal interest rates. Second, what drives the Phillips correlation between inflation and measures of real activity? We find that the Phillips correlation essentially disappears once we control for goods' relative-price changes. This supports modern theories of inflation dynamics based on price rigidities and many consumption goods.

Suggested Citation

Reis, Ricardo A.M.R. and Watson, Mark W., Relative Goods' Prices, Pure Inflation, and the Phillips Correlation (November 2007). NBER Working Paper No. w13615. Available at SSRN: https://ssrn.com/abstract=1032868

Ricardo A.M.R. Reis (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Mark W. Watson

Princeton University - Woodrow Wilson School of Public and International Affairs ( email )

Princeton University
Princeton, NJ 08544-1021
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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